RachelKoning Beals

A stampede into fixed income has pushed prices higher and yields lower, heightening concern that a bond bubble is building, especially in Treasurys. Now, the hunt for yield anywhere north of rock-bottom government rates leaves many bond-pickers favoring quality corporate debt for the remainder of 2010 and into next year.

Bond investors in higher-risk areas such as emerging markets and high-yield corporate debt were rewarded for their daring. Emerging market bond funds led all categories with an 8.8% average gain in the quarter ended Sept. 30, bringing the group’s year-to-date advance to 12.7%, according to preliminary data from investment researcher Morningstar, Inc.

In contrast, the higher-rated world-bond category was up 7.2%, and has gained 8.5% so far this year.

Meanwhile, high-yield corporate bond funds were up 6.1% in the quarter and up almost 10% for the year through September.

Treasured Treasurys

Along the Treasury curve, higher prices meant the benchmark 10-year yield at 2.47% fell to within a hair of its January 2009 lows, and five-year yields, near 1.26%, were back at 2008 levels. Yields and price move inversely.

With prices elevated, longer-dated Treasury funds gained 6.7% in the quarter, padding a more than 24% gain for the year, according to Morningstar. With little immediate inflation threat detected, inflation-protected Treasury funds rose a more muted 2.8% for the quarter.

According to Bank of America Merrill Lynch indexes, Treasurys were up almost 3% in the quarter. This third consecutive quarterly gain is the best such streak in two years. Mutual-fund flow data backed up the results. In the first three weeks of September alone, some $20 billion in new cash poured into taxable and municipal bond funds, padding the $60 billion of new money that cascaded into these portfolios in July and August, according to fund-industry trade group the Investment Company Institute.

Demand emerged on several fronts, including from one especially big customer, the Federal Reserve. Treasury prices rose in late September as a $35 billion sale of five- year notes drew the lowest yield since the government began quarterly offerings of the securities in 1976.

Stakes are higher

The likelihood of continued Federal Reserve buying of government bonds will keep a near-term floor under the market, say analysts. But the low-cost opportunity to join the bond party has likely passed, with timing for buying, or selling, complicated by an uncertain global debt situation, a patchy economic recovery that’s slowed from earlier in the year and a Fed no longer confident in the success of past aggressive monetary policy moves and now operating on stand-by.

It’s a high-stakes and high-priced guessing game for the bond market.

“Not only may have the [Federal Reserve’s] policies contributed to an increase in the risk profile of investments throughout the economy, but it may also have driven the prices of long-term bonds towards bubble territory,” says Kieran Osborne, a portfolio manager at Merk Mutual Funds.

“Should we witness a substantial reversal in sentiment, the risk of large movements in price may be compounded, as many investors scramble to exit their positions,” he added. “A significant inflationary shock to the system may prompt such a reaction; a very real threat in our opinion, given the vast amounts of money the Fed has been printing.”

Osborne is looking ahead to the looming U.S. debt bill, and deficit spending that is expected to keep pressure on the U.S. dollar and eventually, upward pressure on interest rates that will sink bond prices. He’s recommending international diversification.

“Many short-maturity international government debt instruments already pay much higher rates than the very low rates available at the short end of the curve in the U.S.,” Osborne said. “We have witnessed many international central banks raising interest rates recently. As such, investors may want to consider investing in international fixed income at the short end of the yield curve.”

Lured by low rates

Thoughtful shopping among company debt is another consideration for bond buyers.

Already, low rates lured companies ranging from Microsoft to DuPont to issue debt over the past few months. The $332 billion in corporate debt sold in the quarter was the third-busiest quarter on record, according to industry data, and gave investors plenty of inventory from which to choose. Read about corporations taking advantage of low-priced debt.

The spread between investment-grade corporate debt and government debt, which measures the extra risk associated with taking on company bonds, narrowed to 1.84 percentage points in September from 1.89 in July. Spreads look to have room to tighten further, Dave Sekera, senior securities analyst at Morningstar, said in a summary of the bond market’s third quarter.

But, he too is cautious. “While it currently appears that most companies should be able to meet third-quarter earnings guidance, we expect the pace of credit improvement and earnings growth will slow in the fourth quarter as the easy year-over-year comparisons become harder,” he said.

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